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April 7, 2014

3 Tips for Investing in Airline Industry

The crisis in Ukraine and economic woes bedeviling emerging markets have dealt blows to an airline industry struggling to get on firmer footing.

Last month, the International Air Transport Association’s revised its outlook for the global aviation industry to $18.7 billion from its previous forecast of $19.7 billion. In its March financial forecast for the global airline industry, the group said the crisis in Ukraine and the ensuing geopolitical risk are putting upward pressure on oil prices again. In addition, the downturn in emerging markets resulting from a serious fall in capital flows has dampened economic growth. That affected the airline industry because emerging market growth has generated proportionately more air travel than in developed travel markets.

And then there’s the continuing news coverage of the missing Malaysian Airlines jetliner. Whether that causes travelers to skip flying is an open question. The stock of the airliner has fallen in recent years, even before the airliner went missing.

Despite the problems, investors like Nick Cowley, portfolio manager for Henderson Global Investors’ Emerging Markets Opportunities Fund, the global airline sector offers opportunities. “After 9/11, many people dismissed investing in the airline industry, and more recently, they have stayed away because of oil prices,” Cowley said. “In the pre-9/11 era, many airlines grew too fast, but today, a number of airlines have changed their business models to cope with higher oil prices and if you look on a case-by-case basis, we still think you can find some well positioned companies that are well managed and have sustainable competitive advantages.”

He listed three things investors should consider before putting their money in the airline industry:

1. The airlines that make for the best investments are those that have succeeded in creating a niche for themselves, Cowley said, either because of where their hub is located or because they have built up strong networks that have given them a competitive edge over others. Turkish Airlines is a great example of this. “If you look at where Istanbul is located and then look at Turkish Airlines compared to its competitors, which are generally Middle Eastern carriers that are operating large aircraft like Boeing and Airbus, it’s clear that Turkish Airlines has an advantage since its competitors haven’t got a market for flights connecting to Russia and elsewhere in Europe,” Cowley said, “But from Istanbul, it’s a four-hour flight to a vast majority of places in Europe and the Middle East, which means Turkish Airlines can operate smaller, narrow-bodied aircraft that are easier to fill up, and thus run efficient, profitable operations.” Cowley also likes Panama’s Copa Airlines, which successfully operates small planes from its main hub to a number of U.S. destinations that are not that far from Panama. “Because these airlines are operating with fairly tight capacity, they end up being profitable, and to business travelers from the U.S., you can see why it makes sense to connect via Panama because it opens up the way to a lot of different places in Latin America,” he said.

2. One of the biggest themes in the airline industry in recent years has been the boom in budget carriers in the emerging markets. In response to the spike in travel, both domestic as well as international, a number of low-cost airlines have sprung up in many emerging market countries such as India, but Cowley warns that these are often not the best companies to invest in, despite the fact that there’s a great deal of domestic air travel in many emerging markets. “The problem for most of these budget airlines is that their competitors are often state owned and ill disciplined and that results in a ‘national champion’ type industry, with a state carrier trying to defend its market share quite aggressively against budget, and you end up with a tight pricing environment that isn’t conducive to business,” he said. Malaysia’s Air Asia, which operates flights throughout the ASEAN region, is an example of this. The airline, similar to Easyjet in Europe, competes head-on against the national carrier and this results in a tough pricing battle that, Cowley said, is not conducive to good business. So even if a budget carrier may be well managed, having to pit itself against a poorly managed competitor doesn’t make for the best fundamentals.

3. Although the overall slowdown in emerging markets will impact the airline industry as well, Asia may face a bigger problem. Among others, there is too much capacity in the Asian airline industry, Cowley said, and that needs to be worked through. He has a more positive outlook on Latin America, where airline travel is still “fairly young in its penetration” and has some good growth potential ahead of it. According to air transport association, Latin American airlines should collectively deliver a profit of $1 billion in 2014.